Labour market reform and the sustainability of exchange rate pegs

Olli Castrén (), Tuomas Takalo and Geoffrey Wood ()
Additional contact information
Olli Castrén: DG Economics, European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany., http://www.ecb.europa.eu/home/html/index.en.html
Geoffrey Wood: Cass Business School, City University, 106 Bunhill Row, London EC7 8TZ, United Kingdom., http://www.city.ac.uk

No 406, Working Paper Series from European Central Bank

Abstract: It is commonly thought that an open economy can accommodate output shocks through either exchange rate or real sector adjustments. We formalise this notion by incorporating labour market rigidities into an “escape clause” model of currency crises. We show that the absence of structural reform makes a currency peg more fragile and undermines the credibility of the monetary authority in a dynamic setting. The fragility is captured by a devaluation premium in expectations that increases the average inflation rate when the currency peg is more vulnerable to “busts” than “booms”. This interaction between macroeconomic and microeconomic rigidities suggests that a policy reform can only be consistent if it renders either exchange rates or labour markets flexible.

Keywords: Exchange rate policy; labour market flexibility; structural reform. (search for similar items in EconPapers)
JEL-codes: E42 F33 D84 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-mac and nep-mon
Date: Written
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Working Paper: Labour market reform and the sustainability of exchange rate pegs (2004)
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